The Tyranny of Bond Benchmarks

With interest rates at historic lows and the number of risk-free assets in the world shrinking, sovereign bonds are becoming an increasingly risky and complex asset class. In this environment, tethering portfolios to benchmark bond indices is fraught with problems.

Over the past three decades, as interest rates trended lower, investors have generally done well sticking to fixed-income benchmarks such as the Barclays Capital US Aggregate Index or the Barclays Capital Global Aggregate Index. But the long-term decline in interest rates—which today stand at record lows—has masked some key problems with a benchmark-centric approach.

With rates certain to rise at some point in the future, now, more than ever, is a good time for investors to think about whether the benchmarks they are tracking are consistent with their investment objectives.

The problem with nearly all bond indices is that they are market-cap weighted. This means that the companies or governments that issue the most debt—and therefore may be undermining their creditworthiness—are the ones that make up the largest share of the index. Conversely, fiscally responsible issuers who have less outstanding debt make up less of the index—and less of the portfolios of investors tethered to the benchmarks.

Japan is a good example of this problem. The Japanese government has issued massive amounts of debt for years in order to finance huge budget deficits. As a result, Japan today comprises about 20% of the Barclays Capital Global Aggregate, roughly twice the country’s share of the global economy by gross domestic product. And Japanese interest rates are paltry, offering little compensation for the risk of inflation. Yet investors who benchmark themselves against commonly accepted global government bond indices are compelled to buy significant quantities of Japanese government bonds. The same applies to a lesser extent to troubled European sovereigns like Spain, Italy, Greece, Portugal and Ireland.

To be sure, some of these countries may offer higher yields to compensate for their greater sovereign credit risk. But is being compelled to own a company or country that issues a lot of debt consistent with the objectives of most fixed-income investors? We don’t think so.

Another problem with benchmarks is what we call index drift. Investors choose a benchmark because it has certain characteristics that are important to them. For example, the duration of the benchmark may match the duration of their overall liabilities. But index characteristics can change over time, while the investor’s objectives remain unchanged.

In fact, under certain market conditions, such changes can occur very quickly, even over a one- or two-year period. For example, the duration of the Barclays Capital US Aggregate jumped from 3.7 years in March 2009 to 5.2 years in June 2011, as the display below shows. Since duration is a measure of a portfolio’s sensitivity to interest rates, that’s a very significant change.

Your Bond Index May No Longer Have the Traits You Soiught

What’s the solution? More than ever, we think it’s essential that investors identify the objective of their fixed-income allocations and consider moving away from traditional benchmarks. Investment strategies can then be tailored to these objectives for better outcomes. The three most common objectives for fixed-income investors are diversification, income and capital preservation.

In future articles, I’ll examine each of these objectives in turn and we’ll take a deeper look at how investors who are prepared to unshackle themselves from benchmarks may be able to improve their risk-adjusted returns.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio- management teams.

Douglas J. Peebles is Chief Investment Officer and Head of Fixed Income at AllianceBernstein.

Douglas J. Peebles

Douglas J. Peebles joined the firm in 1987 and is the Chief Investment Officer of AB Fixed Income. In this role, he supervises all of the Fixed Income portfolio-management and research teams globally. In addition, Peebles is Chairman of the Interest Rates and Currencies Research Review team, which is responsible for setting interest-rate and currency policy for all fixed-income portfolios. He has held several leadership positions within the fixed-income division, having served as director of Global Fixed Income from 1997 to 2004, and then co-head of AllianceBernstein Fixed Income from 2004 until August 2008. He earned a BA from Muhlenberg College and an MBA from Rutgers University. Location: New York

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2 thoughts on “Are Bonds Really Less Risky than Equities?

  1. Hi Patrick,

    Fascinating study. Thank you for sharing it. I was wondering, when you show real returns of stocks broken down by capital gain and dividend yield, are you subtracting the rate of inflation from the capital gain or from the dividend yield or both? In other words, are you showing nominal yield and real capital gain? Or real yield and nominal capital gain? Or some type of adjustment in between. Thanks again for sharing.

    • The methodology applied by the authors of Triumph of the Optimists: 101 Years of Global Investment Returns is to measure real equity total returns and real equity capital gains. I show the dividend yield as the difference between the two. For example, the real equity total return from 1900 to 1910 was 6.8% annualised; the real equity capital gain was 2.0% and we show the difference between the two of 4.8% as the real yield. Incidentally, the returns to the world equity series comprises a seventeen-country, common-currency (US dollar) index and hence real returns are after US inflation.

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